The Fed’s housing market ‘reset’ has us in a housing correction. Here’s what to expect next

The Federal Reserve wasn’t a fan. As the pandemic housing boom raged along, it pushed up prices across the economy. Higher home prices pushed up rents. Elevated homebuilding levels—which hit a 15-year high during the pandemic—put upward price pressure on everything from windows to lumber while also adding stress to an already stressed global supply chain. Not to mention, cash flowed into the economy from homeowners who tapped into that record home equity.

That’s why the central bank, who has a mandate from Congress to tackle runaway inflation, has targeted the U.S. housing market. How? It put immense upward pressure on mortgage rates. While the Fed doesn’t directly set mortgage rates, it has the levers to see that financial markets do so. Once the Fed made it clear this year what lay ahead for monetary tightening, markets quickly pushed the average 30-year fixed mortgage rate above 5%.

In June, Fed Chair Jerome Powell finally made it clear this is all by design. Powell would like to see the U.S. housing market return to a more balanced state. In his own words, he calls it a “reset.”

“I’d say if you are a homebuyer, somebody or a young person looking to buy a home, you need a bit of a reset. We need to get back to a place where supply and demand are back together and where inflation is down low again, and mortgage rates are low again,” Powell told reporters last month. “We saw [home] prices moving up very, very strongly for the last couple of years. So that changes now. And rates have moved up. We are well aware that mortgage rates have moved up a lot. And you are seeing a changing housing market. We are watching it to see what will happen. How much will it really affect residential investment? Not really sure. How much will it affect housing prices? Not really sure.”

Already, spiking mortgage rates have pushed the U.S. housing market into cool-down mode. As April and May housing data trickled in, it became clear the pandemic housing boom was fizzling out. In June and July, the pace of the cooling picked up.

To find evidence of the accelerated rate of cooling, just look at inventory data. Among the nation’s 100 largest housing markets, the median market saw inventory rise 1% between January and April, according to Fortune‘s analysis of realtor.com data. That was before spiking mortgage rates kicked off the housing correction. Among those same 100 largest housing markets, the median market saw inventory rise 50% between April and June.

Across the country, the U.S. housing market is slowing. Mortgage applications are down 17% on a year-over-year basis, according to the Mortgage Bankers Association. New home sales and existing home sales are falling sharply. Homebuilding has slowed. And more home sellers are slashing their list price.

That said, this housing correction—or as Fortune calls it, the Great Deceleration—is hardly uniform across the country. It has hit Southwest, Mountain West, and West Coast housing markets particularly hard. Among the 10 housing markets that have seen inventory levels rise the most this year, every single one is located in those regions. That group is led by Sherman, Tex. (+332% inventory); San Francisco (+285%); Santa Fe (+272%); Denver (+247%); and Austin (+220%).

The reason? Across the nation, the pandemic housing boom saw home prices become detached from underlying economic fundamentals. That detachment has been even more pronounced in markets across the Southwest, Mountain West, and West Coast. Now that mortgage rates are above 5%, buyers in those "overvalued" markets are feeling particularly squeezed. Some would-be buyers are choosing to remain on the sidelines. Others simply can't afford a mortgage at a 5% rate.

Heading into the year, Logan Mohtashami, lead analyst at HousingWire, was already clamoring for higher mortgage rates. His thinking was that higher mortgage rates would be the only way to sideline buyers and allow inventory breathing room to climb to a healthier level. So far, Mohtashami likes what he's seeing.

"We still have some work to do to get a balanced market. However, with higher rates, we have a shot to get back to peak inventory levels in 2019, which is a balanced market," Mohtashami says. "All my inventory issues go away once we are back to 2019 levels, and only then can I remove the savagely unhealthy housing market theme."

While inventory is rising quickly, it still remains far below pre-pandemic levels: Among the 917 regional housing markets measured by realtor.com, 601 markets are still at least 50% below their pre-pandemic level. Mohtashami wants to see that gap close.

For months, Moody's Analytics chief economist Mark Zandi has been calling this slowing a "housing correction." He doesn't see it stopping this year. Through the summer, he expects home sales to continue falling. By this time next year, Zandi expects year-over-year home price growth to slow to 0%. That'd be quite the deceleration considering that the latest reading sits at 20.4%.

But not every housing market will be so lucky. The pandemic housing boom saw markets like Phoenix, Boise, and Las Vegas become what Moody's Analytics deems significantly "overvalued." Now they're at risk of a price correction. As inventory in those places continues marching upward, Zandi predicts those significantly "overvalued" markets will see home prices fall by 5% to 10%. But if a recession actually materializes, Moody's Analytics predicts U.S. home prices would fall by 5% while significantly "overvalued" markets, like Charlotte and Tampa, would see home prices fall by 15% to 20%.

Want to stay updated on the housing correction? Follow me on Twitter at @NewsLambert.